Current techniques for valuing an entity, such as a business, consider the numerous factors associated with the entity to calculate its value. Business valuation techniques are commonly used by accountants, appraisers, attorneys, bankers, brokers, mergers and acquisitions advisors, valuation firms, buyers and sellers to determine market value of the entity. Business valuation techniques may also be used as tools to aid a business owner in maximizing shareholder value.
There are many methods of business valuation currently used. However, these methods produce business valuation results with a wide range of market values. It is not unusual to observe a 3:1 or 5:1 difference between the high and low values generated by the various methods. Each method considers different variables and factors and associates the variables to one another in a variety of ways. This leads to vastly different business valuations that can be generated with a subjective bias and to serve the varying interests of the parties involved in the transaction. Additionally, traditional valuation methods do not adequately address deal structures.
Traditional business methods fall into one of three categories: (1) asset based valuation; (2) market comparable valuations; and (3) earnings based valuations. According to asset based valuation methods, the value of the business is equal to the value of the business's assets. These methods can produce a multitude of results because the book value, adjusted book value, fair market value or liquidation value of the assets all may be used in the calculation.
According to market based evaluation methods, the value of the business is equal to a multiple of a business parameter. The multiples are derived from actual transaction data from similar businesses. The most common business parameter used is earnings. However, for non-publicly traded companies, there are numerous definitions of earnings including actual earnings or adjusted earnings, earnings before the business owner's salary or after, earnings before interest or after interest. As a result, the market multiples method generates a broad range of valuations depending on how the multiple is calculated and which business parameter the method uses.
Earnings based valuations generate a value of the business by using the appropriate cost of capital to calculate the present value of future earnings or cash flow. However, earnings can be defined as, for example, earnings before taxes (EBT), earnings before interest and taxes (EBIT), earnings before interest, taxes, depreciation and amortization (EBITDA), pre-tax earnings or net income. Similarly, cash flow can be defined as, for example, net income plus depreciation minus capital expenditure. Additionally, the cost of capital is calculated with multiple assumptions. For example, the cost of capital can be defined using equity risk premium, size premium, liquidity premium, industry risk adjustment or company specific risk adjustment. Further complicating the calculation are the numerous methods utilized to generate the valuation, i.e. capitalization of earnings, excess earnings, discounted future earnings/cash flow. Earnings based methods do not address the debt repayment schedule of the acquisition debt. All of these assumptions, variables and methods generate a broad range of valuations.
Currently, there are a number of commercially available valuation software programs. Most valuation products provide multiple business values for a single business because the products utilize many different valuation methods. Many of these software programs require many input variables and input screens, and are subjective with respect to the inputted values. This makes it virtually impossible to understand the impact of the various input on the value of the business.